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What the US can learn from China's response to the stock market crash

Federal Reserve Chair Janet Yellen.
Federal Reserve Chair Janet Yellen.
Alex Wong/Getty Images

There's a lot to criticize about how the Chinese government has handled the recent stock market turmoil. Over the past two months, Chinese regulators have banned some executives from selling shares, ordered other companies to buy shares, and provided government funds to finance debt-funded stock speculation. Those steps were only going to make things worse in the long run.

But this week, China's government did something that made sense: It loosened monetary policy. By flooding the economy with cash and lowering interest rates, China's central bank hopes to cushion the economic downtown and hasten a recovery.

Central bankers in the United States and Europe would be well advised to follow China's lead. They can't do exactly what China did because interest rates here and in Europe are already at zero. But the US Federal Reserve and the European Central Bank can and should be doing more to support economic recovery.

Printing money boosts economic growth

The basic job of a central bank like the Federal Reserve is simple. When the economy is weak, the bank boosts economic growth by expanding the money supply. The limit to this strategy is that printing too much money will create inflation. But in general you should try to boost the economy as much as possible without creating an inflation problem.

Right now, most economic data suggests that the Fed has been doing too little to support the economy. Over the past couple of years, the unemployment rate has fallen to 5.3 percent. That's pretty good, but it could be better. The unemployment rate stayed below that level for multiple years during each of the last two expansions. The economy has also been growing at only about 2 percent per year, below the rate of previous expansions.

And there's no reason to worry about inflation getting too high. To the contrary, prices rose just 0.2 percent during over the last year, far below the Fed's 2 percent inflation target. That's mostly because energy prices have been dropping, but even if you exclude volatile food and energy prices, the inflation rate is still a too-low 1.8 percent.

Of course, just because inflation is low now doesn't mean it will be forever. But fortunately we can also measure market-based expectations of future inflation by comparing how the market values inflation-adjusted and non-inflation-adjusted bonds. According to this measure, markets expect the average inflation rate over the next decade to be below the Fed's 2 percent target:

All of these indicators suggest that the Fed is doing too little to support the growth of the American economy.

And things are even worse in Europe. While Germany and a few other countries are enjoying decent unemployment rates, the unemployment rates in Greece and Spain are reminiscent of America's Great Depression. And inflation in the eurozone is an anemic 0.2 percent, suggesting that the European Central Bank could do a lot more to support the economy without worrying about inflation.

Interest rates are zero, but that doesn't mean central bankers are powerless

Ordinarily, central banks conduct monetary policy by targeting interest rates. When they want to stimulate the economy, they announce that they're going to print more money until short-term interest rates fall to a new, lower level. China did that on Tuesday, cutting a key interest rate to 4.6 percent.

But since the 2008 financial crisis, short-term interest rates in the United States and the eurozone have been close to zero, leaving little room for further rate cuts. That has created a misconception that they can't do more to support economic recovery.

But cutting short-term interest rates is just one way for central banks to boost the economy. Fundamentally, central banks conduct monetary policy by creating new money and using it to buy assets. When a central bank "cuts interest rates," what they're really doing is printing money and buying short-term government bonds with it. That becomes ineffective once short-term interest rates fall to zero. But central banks can always buy other assets.

Indeed, that's exactly what the European Central Bank began doing earlier this year: It began buying long-term government bonds in a program called "quantitative easing." The Fed used the same strategy to pull the US economy out of recession from 2008 to 2014. By 2014, the Fed believed it had done enough to get the economy growing again, and it halted the program.

But the last year's economic data suggests that judgment was a mistake. The US economy is still weak, and more stimulus would be helpful. And while the ECB's bond-buying program was a step in the right direction, it's becoming clear that it should be doing more as well.

The fact that China devalued its currency earlier this month and cut interest rates this week provide an additional reason for easier money in the US. A weaker yuan means that Chinese goods are cheaper in world markets, making it harder for US exporters to compete. Looser monetary policy can boost domestic demand, cushioning the blow for US exporters.

The Fed's big problem is political rather than economic

The past year has seen slow economic growth and very low inflation, which would ordinarily be seen as signs that monetary policy was too tight. Yet in recent months, the Fed has been debating whether to make monetary policy still tighter, by raising interest rates for the first time in six years.

The reason for this is that despite economic data suggesting monetary policy is too tight, many people believe Fed policy is too loose. Before 2008, it had been decades before interest rates had fallen to zero. And so people believe that six years of zero-percent interest rates must be a sign that monetary policy has been dangerously loose.

But the Fed's hawkish critics are mistaken. Six years of zero-percent interest rates are not necessarily a sign that monetary policy has been too loose. Indeed, if we want to eventually return to a "normal" economic environment of non-zero short-term interest rates, the last thing the Fed should do is raise interest rates now.

One way to see this is to think about the situation in the mid-1970s. Back then, the big economic problem facing US policymakers was high inflation. In an effort to combat this inflation, the Fed raised interest rates as high as 10 percent.

That was unusually high, and many people thought this meant monetary policy was tight. But they were wrong: Inflation kept going up. It wasn't until Paul Volcker began as Federal Reserve chair in 1979 that the Fed finally got inflation under control. To do it, Volcker had to jack interest rates up to 20 percent.

Today, the US economy is in the opposite situation. Just as 10 percent interest rates in the 1970s wasn't necessarily a sign of tight money, today's historically low zero-percent interest rates aren't necessarily a sign of loose money. If money were really loose, we'd see a booming economy and rising inflation. Instead, growth and inflation have both been low for the last seven years.

Paradoxically, to get interest rates down in the long run, Volcker had to raise them in the short run. Conversely, if the Fed wants to get interest rates up over the next decade, it needs to keep them at zero now. If the Fed raises rates prematurely, it's likely to stall the economy and force another round of rate cutting.

What the Fed says matters as much as what it does

Restarting the quantitative easing program the Fed ended last year would be a big step that could provoke a political backlash. But the Fed can take a smaller, less controversial step to support the economy: announce that it won't be raising interest rates until well into 2016.

Fed statements about future policy changes can be surprisingly powerful, because businesses take future economic forecasts into account when making business decisions. By signaling that interest rates will stay at zero for many more months, the Fed can give businesses more confidence that investments they make today won't be undermined by a 2016 recession. And that can become a self-fulfilling prophecy: Rising business investment itself helps to boost the economy.

Europe's central bank already has a quantitative easing program. The question is whether it should make the program bigger or pledge to continue it for longer. Currently, the ECB has only committed to continuing the program until September 2016. But it could follow the strategy of the Fed's last QE program: Rather than announcing a specific end date, it could pledge to continue the program as long as it took to hit macroeconomic targets such as higher inflation and lower unemployment. It could also increase the size of the program.

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